CAPM or Fama–French Model: Which Discount Rate Should You Use in Business Valuation?

Introduction: The Battle Behind Your Discount Rate

Choosing the right discount rate is one of the most emotionally charged decisions in the entire field of business valuation. It’s the point where your expertise collides with uncertainty, and where small changes in inputs can produce massive swings in value. When valuators sit down with a spreadsheet or valuation software, they aren’t just crunching numbers—they’re making a judgment call about a business’s future. That pressure can feel overwhelming, especially when you know clients are relying on your work for major decisions like investments, acquisitions, or internal planning. That’s why the debate between CAPM and the Fama–French model matters so much; it isn’t just academic—it directly shapes the story you tell about a company’s worth.

What CAPM Really Represents (and Why People Still Love It)

The Capital Asset Pricing Model has been around for decades, and despite its age, it still holds a special place in the hearts of many valuation professionals. One of the biggest reasons is its elegant simplicity: one formula, one beta, one premium, and you’re done. Many valuators trust CAPM because it’s widely taught in universities, widely referenced in textbooks, and widely accepted by auditors and financial institutions. There’s comfort in using a model that “everyone else uses,” especially when you need to defend your numbers in front of clients or regulators. CAPM feels like a reliable old friend—predictable, easy to explain, and unlikely to spark debate.

How CAPM Calculates the Discount Rate

CAPM follows a beautifully straightforward formula that many valuators can perform almost from memory. The cost of equity is simply the risk-free rate plus beta multiplied by the equity risk premium. Each component is intuitive: the risk-free rate compensates for time, beta captures sensitivity to market movements, and the equity risk premium accounts for the extra return investors demand. This clarity makes CAPM especially appealing when working with clients who are not financially savvy. They appreciate a model that doesn’t bury them in complexity or obscure factors.

A Numerical Example: CAPM in Action

Let’s look at a simple yet realistic example to show the mechanics of CAPM. Imagine you’re valuing a small private company with a risk-free rate of 4%, a beta of 1.2, and a market premium of 6%. When you plug those numbers into the formula, you get a cost of equity of 11.2%—a clean, digestible result. If you use this discount rate in a DCF, the business will look more valuable simply because the discount rate is relatively low. Many valuators end up relying on CAPM by default because it produces valuations that feel optimistic yet defensible.

Where CAPM Falls Short (Especially for Private Firms)

While CAPM has strengths, it also has serious blind spots when applied to small or privately held businesses. For example, it assumes that market risk is the only type of risk that matters, which simply isn’t true in the messy world of real businesses. Private firms face challenges like customer concentration, financing constraints, limited geographic reach, unpredictable cash flow patterns, and owner dependence. None of these risks show up in beta, which is based on public companies that operate on a completely different scale. This means CAPM often underestimates true risk and inflates valuation results for small business clients.

The Fama–French Model: A More Nuanced Lens

The Fama–French model steps in precisely because CAPM was failing to explain how real returns behave in the real world. This more advanced model digs deeper, capturing additional risk factors that significantly affect small and medium-sized businesses. It includes not just market risk, but also size and value premiums—two powerful forces that have been proven repeatedly in empirical studies. For valuation professionals, this model offers a richer, more accurate way of assessing risk. While it may feel more complex, it also feels more honest, especially when the business in question has characteristics that CAPM simply overlooks.

Three Factors That Change Everything

The three core factors in the Fama–French model—market, size, and value—combine to paint a more complete picture of business risk. The size premium reflects how smaller companies tend to face greater volatility and higher uncertainty. The value premium recognizes that companies with certain financial characteristics historically produce higher returns. These factors matter deeply in private business valuation because small businesses simply don't behave like large, established public firms. By capturing these nuances, the Fama–French model offers a more grounded and realistic discount rate.

A Numerical Example: Fama–French Discount Rate

Using the same business from the CAPM example, let’s apply the Fama–French approach. The risk-free rate stays at 4%, and the market factor remains 7.2%. This time, we add a size premium of 3% and a value premium of 1.5%. Suddenly, the discount rate rises to 15.7%, a full 4.5% higher than the CAPM estimate. This dramatic increase reflects the very real risks that small firms carry—risks that CAPM simply glosses over.

Why Fama–French Often Produces More Realistic Valuations

When your discount rate jumps from 11.2% to 15.7%, the valuation outcome shifts dramatically. A business generating $500,000 of free cash flow may be worth over $4.4 million under CAPM, but only $3.18 million under Fama–French. That difference is enormous and can change the direction of deals, negotiations, or investment decisions. Although clients may prefer the higher valuation, the lower one is often more defensible and more aligned with real-world risks. As a valuator, your job is not to tell clients what they want to hear, but what they need to understand.

Where the Fama–French Model Gets Complicated

Despite its accuracy, the Fama–French model does come with challenges. You need access to detailed datasets, updated risk premiums, and reliable benchmarks to compute the factors correctly. Explaining the model to clients can also be tricky, especially when the discount rate jumps higher than expected. Many valuators feel uncomfortable defending a model that clients don’t fully understand. This is where supportive software tools become indispensable—they help bridge the gap between complexity and clarity.

The Emotional Tug-of-War for Valuators

Every valuation professional knows the emotional struggle of choosing the “right” model. You want to be thorough, but not overly complicated. You want to be accurate, but not overly pessimistic. You want to respect academic research, but also deliver a result that clients can digest without confusion. This tug-of-war between CAPM and Fama–French isn’t just technical—it’s deeply emotional because it shapes how clients perceive your expertise and your judgment.

So Which Should You Use?

There is no universal answer, but there is a smart approach. For large and stable companies, CAPM is often enough. For small, medium, or high-risk private firms, the Fama–French model—or at least its size factor—is almost always more realistic. Many valuators use a blended approach, starting with CAPM but adding a size premium to reflect additional risk. The goal is to use a model that represents the business honestly without overwhelming the client.

How Equitest Helps You Choose the Right Discount Rate

This is where Equitest’s AI-powered business valuation engine changes the game entirely. It analyzes the company’s characteristics and automatically evaluates whether CAPM or Fama–French is a better fit. Instead of manually searching for risk premiums or debating which model to use, Equitest generates a complete, defensible, and clearly explained discount rate in seconds. The system translates complex academic models into simple, understandable insights for clients. This saves time, reduces stress, and elevates the professionalism of your entire valuation process.

Numerical Example Using Equitest

Imagine uploading financial statements for a small retail company into Equitest. Within moments, the system detects that the business is small, volatile, and exposed to certain risk factors. It calculates the CAPM discount rate at 11.2%, the Fama–French rate at 15.9%, and recommends the latter because it reflects the true level of risk. No guesswork, no confusion, and no fear of auditor pushback. Equitest gives you clarity and confidence built directly into the calculation.

The Bottom Line

At the end of the day, your discount rate isn’t just a mathematical output—it’s a reflection of your skill and your responsibility as a valuator. The difference between CAPM and Fama–French can determine whether a client overpays, underpays, or truly understands a business’s risk profile. Instead of choosing based on habit or pressure, you can choose based on accuracy, supported by modern AI tools like Equitest. When you have the right tools, valuation becomes not just easier—but more honest, credible, and impactful. Your clients feel the difference, and so does your professional confidence.

Conclusion

Choosing the right discount rate is one of the most defining choices in business valuation. CAPM brings simplicity and familiarity, while the Fama–French model brings depth and realism. Each model has strengths, but the key is matching the model to the business, not the other way around. With Equitest, the guesswork disappears because AI evaluates risk factors objectively and transparently. When your discount rate is accurate, your valuation becomes powerful, meaningful, and trustworthy.

FAQs

1. Is CAPM still acceptable for business valuation today?
   Yes, especially for large companies, but it may underestimate risk for smaller firms.
2. Does Fama–French always produce higher discount rates?
   Often yes, because it captures additional risk factors like size and value.
3. Why do auditors sometimes prefer CAPM?
   Because it’s simpler and has decades of widespread usage behind it.
4. Can I manually add a size premium to CAPM instead of using Fama–French?
   Absolutely—many valuators do this as a middle ground.
5. How does Equitest improve the discount rate calculation?
   By analyzing company data and automatically selecting or adjusting the risk model for the most realistic and defensible result.